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Goldberg's Picks: Top Funds for Investing in Emerging Markets

Stock prices are cheap, and growth prospects are terrific in developing markets.

The world is a mess. The Middle East and North Africa are in turmoil, holding the potential to wreak havoc with oil prices. The Japanese earthquake, tsunami and nuclear disaster are likely to lead to weaker global growth. And the Eurozone seems forever stuck in a slow-motion debt crisis.

Emerging markets have their own internal problems. Many are growing so rapidly that inflation has heated up. Central bankers are raising interest rates to contain inflation before it gets out of hand, but without braking so hard that their actions cause recessions. No wonder emerging-markets stocks were down for much of the year (though they’ve rebounded nicely over the past few weeks; through April 1, the MSCI Emerging Markets Stock index is up 3.4%).

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But even if the worst happens, and emerging markets -- hurt by rising food and fuel costs and lower demand for their products from the developed world -- sink into recession, the long-term case for investing in stocks from developing markets remains as strong as ever.

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For starters, the stocks are cheap. On average, emerging-markets stocks trade at just 12 times estimated earnings for the next 12 months. That makes them less expensive than U.S. stocks, which trade at 14.4 times estimated forward earnings.

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Says Gonzalo Pangaro, lead manager of T. Rowe Price Emerging Markets Stock (symbol PRMSX): “The stocks are attractive for the growth you get. All the reasons to be bullish -- higher growth than anywhere else, favorable demographics, urbanization -- are still there.”

But volatility in emerging-markets stocks is frighteningly high. During the 2007-09 bear market, when Standard & Poor’s 500-stock index plunged 55.3%, the MSCI Emerging Markets Index plummeted 60.2%.

You need to look at developing nations in two ways: They are the fastest growing part of the global economy and are likely to remain that way for many years. But they are also the most volatile part of the global economy.

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Corporate governance and transparency in emerging markets is nowhere near what it is in the developed world. In China and Russia, in particular, the government picks corporate winners and losers.

In my view, long-term investors should have about 15% of their stock money in emerging markets. In other words, buy these stocks, but don’t overdo it.

Many, if not most, multinational corporations are doing increasing amounts of business in emerging markets. That means stocks of U.S. companies and firms in other parts of the developed world are also benefiting from the torrid growth in emerging markets.

My favorite emerging markets fund is American Funds New World A (NEWFX), which invests in both emerging-markets stocks and shares of multinationals doing a lot of business in developing nations. Unfortunately, you can’t buy the fund without going through an adviser. (If you do use a broker or an adviser, ask for the F-2 class shares, which have no sales load and charge just 0.76% annually; of course, you’ll have to pay your adviser in some way.)

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A first-class, actively managed, no-load fund is hard to find. T. Rowe Price’s Pangaro, with a team of 25 analysts, has the resources and talent to do the job. But the Price fund’s record, and that of all the other no-load, diversified emerging-markets funds that I’ve researched, doesn’t instill confidence. Over the past ten years through April 1, the Price fund returned an annualized 16.0% -- matching the gain of the MSCI Emerging Markets Index.

But what’s nettlesome is that the fund has been 38% more volatile than the MSCI index. Volatility is a good predictor of down-market performance (VALUE ADDED: Consider Fund Volatility -- or Risk Paying a High Price), and the Price fund indeed tumbled 66.8% during the last bear market, 6.6 percentage points more than the MSCI index fell.

The fund’s 1.27% annual expense ratio is below average among emerging-markets funds, but 1.27% is a lot of money -- especially for performance that has merely matched the index and done so with much more volatility. Still, Pangaro has been at the helm for only two and a half years, and I think the fund’s performance will improve under his stewardship. (The fund is a member of the Kiplinger 25.)

In contrast, Vanguard Emerging Markets Index ETF (VWO) charges just 0.22% to track the MSCI index. It strikes me as odd that an index fund should be such a good performer in emerging markets. Common sense tells you that active managers should excel in emerging markets, where information about companies is relatively scant. But the record doesn’t support that notion. Perhaps index funds, which trade little, perform better than actively managed funds because of the high costs of trading in emerging markets.

But whether you prefer index funds or actively managed funds isn’t really the key issue. What’s important is that you need to be in emerging markets -- and to invest more when they suffer their periodic swoons.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.

WATCH OUR VIDEO: INVESTING IN EMERGING MARKETS

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